Inflation Dynamics in Sri Lanka: An Empirical Analysis Inflation Dynamics in Sri Lanka: An Empirical Analysis

Inflation
InflationDynamics
DynamicsininSri
SriLanka:
Lanka:An
AnEmpirical
EmpiricalAnalysis
Analysis
Sanduni Kulatunge 1
Sanduni Kulatunge 1
Abstract
This paper examines the dynamics of inflation Abstractin Sri Lanka using the cointegration
approach on quarterly time series data. Considering recent empirical studies in the
This paper
context examines
of inflation the dynamics
in emerging of inflation
countries in Sri
including Sri Lanka
Lanka,using the cointegration
an empirical model
approach on quarterly time series data. Considering recent
has been constructed with seven variables; namely inflation, economic growth, empirical studies in the
context of expenditure,
government inflation in emerging
exchange countries
rate, moneyincluding
supply, Sri Lanka,
oil prices andaninterest
empirical
rates.model
has been constructed with seven variables; namely inflation, economic growth,
The main determinants
government expenditure,of exchange
inflation rate,
in Srimoney
Lanka are the
supply, oil economic
prices andgrowth,
interestexchange
rates.
rate, government expenditure, money supply, oil prices and interest rates in the long
TheAccording
run. main determinants of inflation
to the estimated in Sriresponse
impulse Lanka are the economic
functions, growth, exchange
both domestic shocks
rate, government expenditure, money supply, oil prices
(money supply, interest rate and economic growth) and external shocks and interest rates (exchange
in the long
run.and
rate According
oil prices)tohave
the anestimated
effect onimpulse
inflationresponse functions,
in the short both domestic
run. These shocks
findings would
(money supply, interest rate and economic growth) and external shocks
be useful for policy makers in their effort in maintaining price stability in Sri Lanka (exchange
onrate and oil prices)
a sustainable basis.have an effect on inflation in the short run. These findings would
be useful for policy makers in their effort in maintaining price stability in Sri Lanka
on a sustainable basis.
Key Words: Inflation, Money Supply, Co-integration, Error Correction Model
JEL
Key Classification:
Words: Inflation,E31, E51,
Money E52Co-integration, Error Correction Model
Supply,
JEL Classification: E31, E51, E52
1. Introduction

11
T Theheauthor
authorwishes
wishestotothank
thankProf.
Prof.Kerry
KerryPatterson
PattersonofofUniversity
UniversityofofReading,
Reading,UK UKand andDr.Dr.Susantha
SusanthaLiyanaarachchi
Liyanaarachchi
of University
of Universityof Griffith, Australia
of Griffith, forfor
Australia their guidance
their andand
guidance advice. The
advice. Theauthor
authoris isalso
alsothankful
thankfultotoDr.
Dr.Anil
AnilPerera,
Perera,
Mrs.Mrs. Erandi Liyanage,
Erandi Liyanage,Mrs. Amali
Mrs. Priyashanthi,
Amali Priyashanthi,Mrs.
Mrs.Tharaka
Tharaka Hansi,
Hansi,Miss
MissTehani
TehaniFernando
Fernandoand andMrs.
Mrs.Maheshi
Maheshi
Perera of Central
Perera Bank
of Central Bankof of
Sri Sri
Lanka forfor
Lanka thethe
encouragement,
encouragement, support
supportandandvaluable
valuablecomments.
comments.The Theauthor
authoris isalso
also
thankful to anonymous
thankful to anonymous reviewers. Email:
reviewers. sanduni@cbsl.lk.
Email:
Sanduni@cbsl.lk.
31
3131
Central Bank of Sri Lanka – Staff Studies – Volume 45 Numbers 1 & 2
1. Introduction
Inflation is an important macroeconomic variable. It can be defined as a sustained rise in the
general level of prices i.e. a persistent rise in the price levels of commodities and services,
leading to a fall in the currency’s purchasing power. Low inflation environment provides a
better environment for economic growth, encourages investors, employment opportunities
and higher living standards. It is widely accepted that the pursuit of price stability is primary
to long-run growth and development and should be the concern of every economy (Mallik,
2001; Kihangire, 2005; Odusunya and AbdulMalic, 2010; Bashir et al., 2011; Bhattacharya,
2013). Higher inflation causes adverse impacts on the economic performance of countries in
many aspects and hence, the identification of determinants of inflation is very important.
Inflation reduces real value of money and tends to deteriorate the purchasing power parity of
money in the country. In particular, higher inflation weakens export competitiveness and
discourages exporters. According to Sahaduhhen (2012), unpredicted running and galloping
inflation are regarded as unprecedented effects on an economy because they distort and
disrupt the price mechanism, discourage investment and saving, adversely affect fixed
income groups and creditors and ultimately leads to the breakdown of morals.
The stabilisation of the general price level has become a major macroeconomic objective of
the monetary authorities in many other countries including Sri Lanka (Colombage, 2005).
An analysis of the economic history reveals that inflation has been a major issue for policy
makers in Sri Lanka. Table 1 provides a comparison of inflation rates in Sri Lanka with other
economies and illustrates that except for Sri Lanka and emerging market and developing
economies, all other regions maintain their inflation at low levels.
Table 1: Sri Lanka and World Inflation (Annual Average % Change)
Country 1980 1990 2000 2010 2013

Sri Lanka 26.1 21.5 6.2 6.2 6.9
World 17.9 27.7 4.6 3.6 3.8
Advanced economies 13.7 5.1 2.3 1.5 1.4
Euro area n/a n/a 2.2 1.6 1.5
Major advanced economies (G7) 12.4 4.7 2.2 1.4 1.3
European Union 12.6 27.5 3.1 2.0 1.7
Emerging market and developing
n/a 98.7 8.6 5.9 6.2
economies
Developing Asia n/a 7.7 1.9 5.3 5.0
ASEAN-5 17.4 9.2 2.8 4.4 4.9
Source: Database of World Economic Outlook (2013)
32
32
Inflation Dynamics in Sri Lanka: An Empirical Analysis
Maintaining economic and price stability are core objectives of modern central bank
practices. Similarly, maintaining low inflation has become a major objective of the
government and the Central Bank of Sri Lanka (CBSL). Therefore, investigating the effect of
key macroeconomic variables on inflation is vital for policy makers in the pursuit of their
efforts to maintain macroeconomic stability.
Sri Lanka suffered from approximately 30 years of internal conflict only ended in 2009,
which arguably is a major obstacle for the country’s economic growth. Currently, Sri Lanka’s
economy is facing two challenges in terms of the high economic growth which commenced
since the end of the internal conflict and the need to maintain macroeconomic stability to
create the conditions for economic growth. Hence, maintaining a low inflation level has
become important for Sri Lanka especially after the ending of the internal conflict. In
particular, as Ratnasiri (2009) aptly claims, the identification of determinants of inflation and
forecasting remain vital for economic agents. Therefore, it is essential to identify the main
causes of inflation in Sri Lanka in order to adopt more viable economic policies. This study
therefore is timely, as identifying the dynamics of inflation in Sri Lanka is essential especially
for policy making purposes.
Similar to other developing countries, Sri Lanka has experienced a high inflation level during
the last few decades. Considering the importance, several attempts have been made to
explore determinants of inflation in Sri Lanka. For example, Weerasekara (1992) using
causality tests, variance decompositions and impulse response functions identifies that the
main source of inflation is the money supply in Sri Lanka. Meanwhile, Ratnasiri (2009)
examines determinants of inflation in Sri Lanka by concentrating on economic factors and
proves that both the demand side and supply side factors affected inflation in Sri Lanka.
According to the findings of Cooray (2008), there is a long run relationship between price
level, real GNP, exchange rate and import prices, exemplifying that supply side factors are
the most important determinants of inflation in Sri Lanka. Bandara (2011) also investigates
the determinants of inflation in Sri Lanka from 1993–2008, a period which was characterised
by upward and downward trends in the economy. This study reveals that money supply,
exchange rate and GDP contain information which helps in exploring the behaviour of
inflation in Sri Lanka. Thus it is evident that these attempts are important in understanding
the behaviour of inflation in Sri Lanka.
The present study, however, differs from the existing literature in the following ways. First,
probing into determinants of inflation requires an explicit examination of the most relevant
set of variables. Considering this, the study attempts to examine main determinants of
inflation in Sri Lanka using a set of variables such as the government expenditure, money
supply, GDP, interest rates, oil prices and exchange rate.2 To that end, this study would

2 Ratnasiri (2009) investigates determinants of inflation using variables of output gap, money supply, rice price,
interest rate and exchange rate depreciation. However, the study does not consider dynamic interaction between
inflation and fiscal variables.
33
33
contribute to the available literature on inflation by focusing on the relationship of inflation

with real, external, monetary and fiscal sectors of the economy, since a limited numbers of
studies investigate the overall impact of macroeconomic aggregates on inflation, which is
helpful for better economic policies. Second, with the consideration of the government
expenditure, this study investigates the fiscal impact on expenditure, which plays a vital role
in an economy. In particular, existing studies on inflation in Sri Lanka do not consider the
effects of government expenditure on inflation, a gap that will be filled through this study.
Third, this study identifies how oil price changes impact inflation, since most of the previous
researchers in this area have not considered the effect of oil price changes on inflation in Sri
Lanka. As Sri Lanka is a net importer of oil, Sri Lanka is vulnerable to spikes in international
oil prices.3 Temporary shocks such as a raise in international oil prices and other commodity
shocks have been dominant inflationary triggers (Goyal, 2011). Finally, the existing literature
has identified there are several types of relationships (such as positive, negative, no
correlation and threshold value) between inflation and other variables. Therefore identifying
such kind of relationships would be important for economic policies. Hence, the findings of
this study would have several important implications for policy makers such as monetary and
fiscal authorities not only for Sri Lanka, but also for respective authorities in other
emerging/developing economies.
Although there are several studies on inflation dynamics in Sri Lanka, there is scope for a
fresh look at the determinants of inflation. Ratnasiri (2009) carried a VAR base analysis to
identify the determinants of inflation in Sri Lanka, covering the period of 1980-2005 only.
Thus this paper attempts to investigate the dynamics of inflation in Sri Lanka for the period
of 2000Q1 to 2013Q4. Moreover, Sri Lanka could maintain inflation at a single digit level
during last six years since 2009 especially after the ending of the internal conflict. Hence,
identifying the determinants of inflation during a low inflation period would be useful for
policy makers in their effort in maintaining price stability in Sri Lanka. Thus, it is evident that
Sri Lanka’s economy has undergone a significant structural change after 2009. After the
ending of the internal conflict, the economy of Sri Lanka has displayed its true potential.
While appropriate demand management policies are required to maintain low and stable
inflation, effective addressing of supply-side impediments is also needed (CBSL, 2010).
Hence, policy makers should continue to adopt appropriate policy measures to maintain
inflation at low single digit level. Accordingly, identifying methods for the investigation of
the overall impact of macroeconomic aggregates on inflation would be needed in order to
sustain domestic price stability in a dynamic economic environment.
The remainder of the paper is structured as follows; Section 2 provides detailed background
information, while Section 3 presents the theoretical background and literature review of the

3 Relevance of external factors on inflation can be gauged most notably by prices of energy, as Sri Lanka is a net
importer of oil. External effects are thought to play an important role in small open economies (Kusper, 2012).
Ratnasiri (2009) uses only exchange rate to capture the external impact on inflation.
34
34
study explaining the different findings of previous research related to the determinants of
inflation. In addition, this section highlights determinants of inflation with special reference
to Sri Lanka. Section 4 explains the methodology, while Section 5 consists of empirical
analysis and Section 6 presents the concluding remarks of the study, which summarise the
empirical findings of the study and the policy implications.
2. Inflation in Sri Lanka

2.1 Overview of Inflation in Sri Lanka
Around 1950, Sri Lanka’s inflation rate was relatively low and was lower than industrial and
developing countries (Rupananda, 1994). Inflation, which is measured by the Colombo
Consumers’ Price Index (CCPI, 1952=100), was 0.07 per cent during the period of
1948-1956. Increase in the general price level remained low during this period mainly due to
the maintenance of a fixed exchange rate regime since 1948, maintenance of price controls
and slower rate of monetary expansion (CBSL, 1998). Table 2 and Figure 1 show annual
percentage changes in inflation in Sri Lanka during the period of 1948-2014.
Table 2: Annual Average Inflation (1948-2014)
Period Inflation (%)

1948-1956
0.07
Post independence open economy
1956-1965
1.2
Closed economy
1965-1970
4.0
Semi open economy
1970-1977
5.7
Closed socialist economy
Since 1977-2014
10.9
Open economy
Source: Central Bank of Sri Lanka
CCPI inflation was relatively low during the period of 1956-1965 as well, averaging 1.2 per
cent due to economic controls such as direct control on international trade and foreign
exchange outflows (CBSL, 1998). On the other hand, the period of 1965-1970, inflation was
moderately high (4.0 per cent) due to the increase in import prices and the devaluation of the
rupee. However, the devaluation of the rupee resulted in increased exports during this
period.
The period of 1970-1977 was characterised by import substitution restrictions under a
protectionist framework, the highest trade restriction ever adopted in Sri Lanka. Inflation
increased to the double digit level of 12.3 per cent for the first time in history in 1974 due to
an oil price hike. Average inflation was around 5.7 per cent during this period.
35
35
Consequently, after introducing open economy policies in 1977, the Sri Lankan economy
was opened to the rest of the world by removing trade barriers and exchange controls.
With the removal of import and exchange controls, imports began to gain greater
significance in affecting prices (Cooray, 2008). Further, after liberalisation, there was a rapid
increase in public investment. This resulted in a rapid growth in the money supply.
According to Weerasekara (1992), there has been a rapid growth in the nominal money
supply and continuous depreciation of the exchange rate after introducing trade liberalisation
policies in 1977. All these reforms resulted in accelerating inflation. The depreciation of the
rupee and abolishment of the dual exchange rate in 1977 caused an increase in import price.
Essential food items such as wheat flour and bread prices were revised upward in 1980, 1981
and 1984. Public transport fares and kerosene prices also increased in 1980 and 1983.
In addition, the government public investment programme, high government capital
expenditure and high budget deficit fuelled higher inflation. As a result, between 1978 and
1984, year on year inflation was 15.9 per cent, recording the highest ever inflation rate of
26.1 per cent in 1980, since independence. However, inflation reduced significantly to
1.5 per cent in 1985. This was the first instance that a single digit rate was achieved since
1977. Enhanced production of most agricultural crops as a consequence of favourable
weather conditions, continued restrictive credit policies, lagged effect of non-expansionary
fiscal policies as well as lower import prices were contributory factors towards the lower
inflation (CBSL, 1985). However adverse weather conditions and the internal conflict of the
country caused an acceleration in inflation to double digit level again in 1988 and 1989.
In 1990, inflation rose significantly up to 21.5 per cent due to the increase in fertiliser prices,
exchange rate depreciation of the previous year, increase in fuel prices and the upward
revision of paddy prices (CBSL, 1990). During the period of 1991-1993 inflation remained
low compared with 1990, due to favourable weather condition and contactionary monetary
policies, but stood at a double digit level. The reduction of domestic food production due to
drought conditions, cutting back of the subsidy on wheat and higher energy prices caused
increased inflation up to a double digit level in 1996 (CBSL, 1996). Annual average inflation
increased up to 15.9 per cent in 1997 and reduced to 4.2 per cent in 1999 mainly due to fiscal
discipline, prudent monetary management, low import prices and tariff structure. Again,
higher international commodity prices, currency depreciation and supply shortages in the
country caused increase in inflation up to 14 per cent in 2001.
36
36
Figure 1: Annual Inflation in Sri Lanka

30.00
25.00
20.00
(% changes)
15.00
10.00
5.00
0.00
-5.00 1971
2001
1953
1956
1959
1962
1965
1968
1974
1977
1980
1983
1986
1989
1992
1995
1998
2004
2007
2010
2013
Sri Lanka experienced relatively low inflation in 2003 due to favourable domestic production
and continued focus of monetary management on price stability. During this period, interest
rates were reduced in order to stimulate the economy. However, international oil prices
started to increase sharply from the end of 2004 and reached historically high levels in 2005,
affecting oil
oil importing
importingcountries
countrieslike
likeSriSri
Lanka adversely.
Lanka In 2007
adversely. inflation
In 2007 increased
inflation by 17.5
increased by
per
17.5cent
per on
centyear-on-year basis owing
on year-on-year to continued
basis owing escalation
to continued of global
escalation oil andoil
of global gasand
prices,
gas
adverse developments
prices, adverse of international
developments of international commodity prices,
commodity reduction
prices, reductionofofdomestic
domestic food
production due to disturbance in major paddy production in the North and East due to
terrorist activities and adverse weather conditions (CBSL, 2007).
By 2009 inflation reduced to single digit levels of 3.4 per cent, which was the lowest inflation
recording in more than two decades. Both demand and supply side factors such as stringent
monetary policy measures adopted by the CBSL, improved domestic supply conditions,
decline in international commodity prices and stable exchange rate resulted in lower inflation
during the year
year (CBSL,
(CBSL, 2009).
2009). Inflation
Inflationhas
hascontinued
continuedtotoremain
remainatatthe
a single
single digit
digit level since
then, recording 6.2 per cent, 6.7 per cent, 7.6 per cent, 6.9 per cent in 2010, 2011, 2012 and
2013, respectively. Increase in domestic food supply, monetary policy measures adopted adapted by
the CBSL and downward tariff revisions to some consumer items caused low inflation in
2011, whereas improved supply conditions of agricultural production, downward revisions
of some administered prices and duties on imported items and demand management
strategies, together with managed inflation expectations, were the main drivers for low
inflation in 2012 (CBSL, 2012). According to the CBSL (2013), prudent monetary
management and improved domestic food supply led to a gradual decline in headline
inflation, while core inflation was moderated to its lowest level by 2013, reflecting effective
demand management policies and the lagged effect of the tight monetary policy stance in
2012. Due to the combined impact of prudent monetary management, relatively stable
exchange rate, moderation in international commodity prices, fiscal policy measures taken
37
37
towards addressing supply side disturbances and well managed inflation expectations by end
2014, year-on-year and annual average inflation were recorded at 2.1 per cent and 3.3 per
cent, respectively (CBSL, 2014). Inflation on a year-on-year basis remained in the negative
territory at -0.3 per cent for the third consecutive month in September 2015, supported by
improved domestic supply conditions and subdued global commodity prices such as crude
oil, dairy products, and wheat and maize.
It is observed that inflation has been significantly volatile in Sri Lanka and it was mainly
determined by both demand side and supply side factors during the period of 1948-2013. It
is essential to quantify the main sources of inflation in Sri Lanka, which may have caused
such volatility in inflation in order to adopt better economic policies.
2.2 Measures of Inflation in Sri Lanka

Three major indicators such as CCPI, Wholesale Price Index (WPI) and Gross Domestic
Product Deflator (GDPD) are used to measure changes in the general price level. The CCPI
is the official cost of living index in Sri Lanka and currently 2006/2007 is taken as the base
year. The CCPI is widely used by firms and individuals in planning current and future
consumption and investment. It is compiled by the Department of Census and Statistics and
is available on a monthly basis.
The CCPI covers a large number of commodities and is heavily weighted towards food items
which comprise 41 per cent of the index. Housing, water, electricity, gas, and other fuels and
transport items weighted 24 per cent and 12 per cent, respectively, in the commodity basket.
The main categories of the commodity basket and their respective weights are shown in
Table 3.4
The other available price indices are the WPI and the GDPD. These indices differ in terms
of the goods and services included in the consumer basket, weights assigned to each item,
geographic area of price collection, population coverage and the base year.

4 Department of Census and Statistics is in the process of introducing a National Consumer Price Index (NCPI).
38
38
Table 3: Colombo Consumers’ Price Index: Weights by Main Categories

Category CCPI Base CCPI Base
2002=100 (%) 2006/07=100 (%)
1. Food and Non-alcoholic Beverages 46.7 41.0

2. Clothing and Footwear 3.1 3.1
3. Housing, Water, Electricity, Gas and Other fuels 18.3 23.7
4. Furnishing, Household Equipment and Routine Household 3.2 3.6
Maintenance
5. Health 4.2 3.2
6. Transport 9.5 12.3
8. Communication 4.4 4.8
9. Recreation and Culture 2.2 1.5
10. Education 5.8 3.9
11. Miscellaneous Goods and Services 2.7 2.9
Total 100.0 100.0
Source: Department of Census and Statistics
Broadly, there are two measures of measuring inflation, namely headline inflation and core
inflation. Headline inflation refers to the rate of change in the overall price index. Factors
like administrative price changes (electricity and transport), increase in imported prices
(crude oil and sugar), adverse weather conditions (landslides, floods and drought), and
seasonal demand due to New Year and Christmas influence headline inflation to exhibit
some volatility. Core inflation reflects demand-pull inflation that responds to demand
management policies. This captures the impact of underlying demand pressures. Inflation
arising due to changes in food and energy prices is volatile and is often subject to temporary
fluctuations caused by supply shocks, driven by weather disturbances or external shocks, and
changes in administered prices or tax policies, which are beyond the control of the monetary
authority. Core inflation excludes such volatile prices. In Sri Lanka core inflation is measured
by excluding certain items such as fresh food, coconut nuts, rice, transport and fuel and
energy, which are either highly volatile or administered prices.
Movements in Headline inflation and core inflation in Sri Lanka are presented below in
Figure 2. In 2009, low levels of headline inflation were recorded compared to high core
inflation. This low inflation was mainly attributed to favourable developments of the supply
side factors such as decline in international commodity prices and revision of domestic
administrative prices. Headline inflation was higher than the core inflation in 2012 due to the
price increases of the non-food category, mainly on account of the upward price adjustment
39
39
for for
fuel
for and
fuel
fuel bus
and
and fares.
bus bus LowLow
fares.
fares. volatility
Low in core
volatility
volatility in in inflation
corecore reflects
inflation
inflation thatthat
reflects
reflects the
thatdemand
thethe driven
demand
demand driven
driven
inflationary pressure
inflationary
inflationary waswas
pressure
pressure well
wascontained
well
well from
contained
contained mid
from
from 2013
midmid till
2013
2013 2014.
till till
2014.2014.
Figure 2: Headline
Figure
Figure Inflation
2: Headline
2: Headline andand
Inflation Core
Inflation andInflation
Core
Core
Inflation
Inflation
12.0%
12.0%
12.0%
10.0%
10.0%
10.0%
8.0%8.0%
8.0%
2006/07 = 100
2006/07 = 100
2006/07 = 100
6.0%6.0%
6.0%
4.0%4.0%
4.0%
2.0%2.0%
2.0%
0.0%0.0%
0.0%
2009May
Sep
2010May
Sep
2011May
Sep
2012May
Sep
2013May
Sep
2009 Jan
Jan
Jan
Jan
2013 Jan
2014 Jan
2014Apr
May
May
2010 Sep
Sep
May
May
2011 Sep
Sep
May
May
2012 Sep
Sep
May
May
Sep
Sep
May
May
Sep
Sep
Jan
2009 Jan
Jan
2010 Jan
Jan
2011 Jan
Jan
2012 Jan
Jan
2013 Jan
Jan
2014 Jan
Apr
Apr
Headline Inflation
Headline
Headline
Inflation
Inflation CoreCore
Inflation
Core
Inflation
Inflation
Source: Department of Census and Statistics
3. Theoretical Background
3. Theoretical
3. Theoretical andand
Background
BackgroundLiterature
and Review
Literature
Literature
Review
Review
3.1 3.13.1Theoretical Background
Theoretical
Theoretical
Background
Background
There
There are are
There various
are theories
various
various of inflation
theories
theories in economic
of inflation
of inflationin economicthought
in economic andand
thought
thoughtnumerous
and
numerousempirical
numerous studies
empirical
empiricalstudies
studies
havehave
been
havebeenconducted
beenconductedon on
conducted theondeterminants
thethe
determinants of inflation.
determinantsof of TheThe
inflation.
inflation.relationship
The between
relationship
relationship inflation
between
between inflation
inflation
andanditsandits
keyitskey
determinants
keydeterminants is an
determinants important
is isan animportantbuilding
important buildingblock
building
blockin in
blockmacroeconomic
inmacroeconomic theory
macroeconomic theory
theory
(Sahadudheen,
(Sahadudheen,
(Sahadudheen,2012).
2012).
2012).
Most of
Most
Mostthe
of oftheories
the the
theoriesof inflation
theories of inflationare are
of inflation formulated
are
formulated on on
formulated theon basis
the the of
basis demand
basis
of demand pullpull
of demand and cost
pull
and andpush
cost
cost
push
push
theories. There
theories.
theories.Thereare are
There a number
are
a number of causes
a number of causes of inflation
of causes which
of inflation
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which
whichrelated
are to expansion
related
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or fiscal
or or policy
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and type
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of of cancan
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referred
be be as demand
referred
referredas demand pullpull
as demand inflation
pull (Mosayeb
inflation
inflation
(Mosayeb
(Mosayeb
andandRahimi,
andRahimi, 2009).
Rahimi, Inflation
2009).
2009). Inflationmaymay
Inflation bemaycaused
be be
caused by by
caused an by
increase
an an in the
increase
increasein inquantity
the the
quantity of money
quantity
of ofmoneyin in in
money
circulation relative
circulation
circulation to the
relative
relative ability
to the
to the of the
ability
ability economy
of the
of the
economy to supply.
economy to supply.When
to supply.When there
When isthere
there anis excess
an
is an demand
excess
excess
demand
demand
in the economy,
in the
in the
economy, producers
economy, producers raiseraise
producers their
raiseprices
their
their andand
prices
prices gain
and higher
gaingain profit
higher
higher margins.
profit
profit
margins. Possible
margins. causes
Possible
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causes
of demand
of of
demand pullpull
demand inflation
pull
inflation are are
inflation higher
are demand
higher
higherdemand from
demand fromgovernment
fromgovernment stimulus,
government stimulus,monetary
stimulus, monetary stimulus
monetarystimulus
stimulus
to to
theto economy,
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economy, faster
economy, economic
faster
fastereconomic growth
economic growth in in
growth other
in countries
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and improved business
improved business
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of of push
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pushpush maymay
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to tocost
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production,
production,
increasing
increasing
wages, higher
wages,
wages, imports,
higher
higher raising
imports,
imports, taxes,
raising
raising budget
taxes,
taxes, deficit
budget
budget andand
deficit fiscal
deficit and deficit
fiscal
fiscal (Bashir,
deficit
deficit 2011).
(Bashir,
(Bashir, If there
2011).
2011). If isthere
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an increase
an an in the
increase
increase costs
in
in the the of
costs firms,
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of of thenthen
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then will
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will the
passpasscost
the thetocost
cost consumers. According
to consumers.
to consumers. to to to
According
According
40
40 40 40
an increase in the costs of firms, then firms will pass the cost to consumers. According to
Sach and Larrain (1993) weather related factors (drought/flood) and failure in harvests
would lead to price increase. Werasekara (1992), Rupananda (1994), Laryea (2001) and
Rathnasiri (2009) find that inflation determinants belong to main demand pull and cost push
inflation theories.
Phillip’s curve suggested by A.W. Phillips in 1958, shows that wage inflation and
unemployment are negatively related. This referred to as the trade-off between inflation and
unemployment. Criticising Phillip’s curve, Friedman (1968) and Phelps (1967) argued that
this trade-off is not stable in the real world. According to them, the long-run Expectation
Augmented Phillips Curve (EAP) was perfectly vertical at the natural rate of unemployment.
Especially during the period of oil crisis, Phillip’s curve seemed to breakdown all together.
When oil price increases, inflation and unemployment increase accordingly. This is called as
stagflation. The breakdown of the original Phillips curve can be explained in the EAP curve
shown below in Eq. 1.
π = π! − β1(u − u∗ ) + E (1)
Inflation = Expected Inflation – (B *Cyclical Unemployment) + Supply Shock
When expected inflation increases, actual inflation also increases in any given unemployment
level. Thus the modern Phillip’s curve depends on expected inflation, the deviation of
unemployment from the natural rate (cyclical unemployment) and supply shocks.
While the traditional Phillips curve is subject to considerable theoretical criticism, the New
Keynesian Phillip’s Curve (NKPC) relates inflation to the output gap and the cost-push
effect influenced by expected inflation. At the cost of a lower output gap, policymakers
could reduce inflation under the concept of the NKPC. Thus, the NKPC is used widely by
academies to explain the effects of past and future inflation on current inflation. The
standard model of the NKPC is in the following form;
!! = !"! !!!! + !"! + !! (2)
Where �π t denotes inflation rate, �
β is the discount factor, Et is expectations operator, xt is
output gap and vt is exogenous shock to inflation process.
According to Gali and Gertler (1999), it is often difficult to detect a statistically significant
effect of real activity on inflation using the structural formulation implied by the theory,
when the measure of real activity is an output gap and failure to find a significant short-run
link between real activity and inflation is unsettling for the story. There are some doubts on
using NKPC to model inflation among researchers. Later, researchers have introduced a
hybrid form of the backward-looking and the forward-looking Phillips curve (Mankiw,
2001). Hence, there are several theories explaining the causes of inflation; however, most of
them are formulated on the basis of the aggregate demand (demand pull) and cost-push
theories of inflation.
41
41
3.2 Empirical Evidence

In addition to the theoretical literature reviewed previously, a number of empirical studies on
inflation will be summarised in this section in order to examine the past experiences on
inflation studies. Inflation could be the result of different sources simultaneously, hence, a
single theory may not be sufficient and a combination of theories may be a good solution
instead (Mosayeb and Rahimi, 2009).
The NKPC has frequently been used in the recent past in order to describe inflation dynamics.
Gali and Gertler (1999) estimate the NKPC equation using the generalized method of
moments (GMM) method. According to their findings, forward-looking behaviour is more
important than backward-looking behaviour. Also, they suggest there is a robust and significant
impact of marginal costs on inflation. Conversely backward looking price setting is not
quantitatively important. Later, some researchers used proxies for marginal cost such as average
unit labour cost. According to Woodford (2001), labour share is a much better measure of the
true output gap for the purpose of explaining inflation variation. Nason and Smith (2008) who
have estimated the NKPC for UK and Canada find that inﬂation tracks real unit labour costs
rather than output gap measures. But some have argued that the output gap is the most
appropriate variable in explaining inflation. However, the NKPC is a better method to estimate
macroeconomic models and the monetary transmission mechanism.
Determinants of inflation have been examined by both developed and developing countries.
It has been identified that there is a large number of factors in determining inflation.
Cougani and Swagel (2001) investigate sources of inflation in 53 developing countries
grouped by region (Africa, Asia, the Mediterranean and South America) and exchange rate
regime (fixed or floating) for the period of 1964 to 1998. According to them, both demand
pull and cost push factors affect inflation in developing countries. Their study shows that for
African countries past realisations of inflation play a main role and accounted for two thirds
of the variance of inflation. In contrast, South America’s main determinant of inflation is
fiscal variables. Their conclusion is faster money growth and exchange rate depreciation lead
to higher inflation, while oil price hikes partly impact inflation.
In a similar vein, Osario and Unsal (2011) engaged in an empirical study to investigate
inflation dynamics in Asia by presenting a two-step quantitative analysis of inflation
dynamics. Those are Global VAR (GVAR) framework which is proposed by Pesaran,
Schuermann and Weiner (2004) in order to estimate inflationary dynamics in the Asia and
Pacific region and structural VAR for each country. Results show that inflation in China and
India are mainly driven by domestic supply shocks. In Asia, commodity prices are especially
a major source of inflation in demand side. Likewise, Moccero et al (2011) investigate the
determinants of inflation in major OECD countries. They have divided OECD countries
into four categories namely, USA, UK, Europe and Japan. They identify that output gap and
unemployment related measures of the intensity of resource use are important factors of
inflation determination in four economies during the recent past.
42
42
Some of the studies find determinants of inflation from monetarist and structuralist
perspectives. Callen and Chang (1999) examined the modelling and forecasting inflation in
India. According to them, India followed monetarist and structuralist approaches for recent
studies on inflation. Their models are based on the monetary approach and output gap and
assessed the ability to forecast inflation development in India. They have used bivariate VAR
estimation, series of granger causality and variance decompositions for their models. Results
show that, money supply is the main determinant of inflation in India and foreign inflation has
some effect on inflation in the short term. Thus, the output gap has some impact on inflation
after one-quarter.
A VAR model is estimated for the period of 2004-2012 by Bhattacharya (2013), in order to
examine major reasons for inflation in Vietnam, which experienced a high inflation level
during the last several decades. Accordingly, nominal effective exchange rate, credit growth
and real GDP are key drivers of inflation in the long run. Especially, there is a strong and
significant relationship between credit growth and inflation in Vietnam. Interest rates of
Vietnam do not have an impact on headline inflation in the short term or medium term
which may reflect the weakness of the monetary policy in Vietnam. On the other hand,
Laryea and Sumalia (2001) reveal that in the short run, output and monetary factors are the
main sources of inflation in Tanzania and the exchange rate plays a main role in the long run.
Proving the monetary theory on inflation, they find that monetary factors are more
important in inflation determinants than real factors in Tanzania and conclude that the
government should adopt a contractionary monetary and fiscal policy to control inflation.
A number of empirical studies have been conducted on the impact of government expenditure
on inflation and theoretical and empirical evidence proves that prolonged fiscal expansions
contribute to inflation and hence, there exists a positive long run relationship between
government expenditure and inflation. Han and Mulligan (2008) carried out the study on three
dimensions of data; cross country data was analysed for the relationship between inflation and
size of government in long run for 80 countries, while time series data were used to identify the
changes in total expenditure in disaggregate levels of defence and non-defence spending. In order
to rectify the possible endogeneity problems in size of the government and non-defence
expenditure, the government spending on social security to output ratio was used. Accordingly,
they found a positive strong relationship between inflation and government’s size during wartime.
Furthermore, non-defence expenditure is negatively related with inflation and it is insignificant.
Conversely, Magazzino (2011) assessed the empirical evidence of the nexus between public
expenditure and inflation for the Mediterranean countries and no clear evidence unveiled
that the government spending caused price dynamics. Based on that study, he proved a long-
run relationship between the growth of public expenditure and inflation, albeit only for
Portugal. Furthermore, Magazzino found a short-run evidence of a unidirectional flow from
expenditure to inflation for Cyprus, Malta and Spain, a unidirectional flow from inflation to
public expenditure in France and a bidirectional flow for Italy.
43
43
3.3 Sri Lankan Context

Several attempts can be observed in relation to the identification of determinants of inflation
in Sri Lanka. These studies include Weerasekara (1992), Rupananda (1994), Bandara (1996),
Colombage (2005), Gunasinghe (2007), Cooray (2008), Ratnasiri (2009) and Bandara (2011)
among others. Most of these studies reveal the importance of both supply side and demand
side factors in the determination of inflation in Sri Lanka.
Weerasekara (1992) reveals that the main source of inflation in Sri Lanka is money supply,
using broad money supply and nominal exchange rate (rupee/US dollar) for the period of
1978 to 1992. Causality tests, variance decompositions and impulse response functions were
performed on the VAR and the result of the model shows that an increase in money supply
causes inflation. Exchange rate changes also caused inflation. According to the findings,
there is bilateral causality between money supply and exchange rate changes.
Cooray (2008) finds a long run relationship between price level, real GNP, exchange rate and
import prices. Two models, which are the known closed economy model based on the
monetarist explanation modified to incorporate the time lags in the adjustment of prices in
the money supply, and the open economy model that incorporates variables of import price
index and foreign exchange rate were used. After the liberalisation of the economy, exchange
rates and import prices became important factors on the general level of prices. According to
findings, supply side factors are most important in the determination of inflation in Sri
Lanka.
Ratnasiri (2009) examines the determinants of inflation in Sri Lanka for the period of
1980-2005 using a VAR based co-integration approach. This study finds that money supply
growth and the increases in rice price are the most influencing factors for inflation in Sri
Lanka in the short run as well as in the long run, while GDP growth and exchange rate
depreciation is not important. Ratnasiri’s study proves that both demand side and supply side
factors affect inflation in Sri Lanka.
Rupananda (1994) highlights that after 1977, import prices and structural factors are more
responsible for increasing inflation in Sri Lanka than monetary factors and indirect taxes
marginally affected changes in price levels. Similarly; Bandara (1996) reveals that exchange
rate and money supply have a large impact on inflation in the long run, while exchange rate
depreciation significantly affects inflation in the short run. However, Colombage (2005)
applies different econometric methods to ascertain the main determinants of inflation in Sri
Lanka. It is shown that money supply plays a significant role in inflation in the short run as
well as in the long run. Meanwhile, Gunasinghe (2007) examines the relationship between
inflation and economic growth by using a co-integration analysis, generalised impulse
response analysis and granger causality test. Results show that there is a negative relationship
between inflation and economic growth. Further, Bandara (2011) investigates the
determinants of inflation in Sri Lanka during the period of 1993-2008. Results of the model
44
44
of inflation show that money supply, exchange rate and GDP helps in the determination of
inflation in Sri Lanka.
In a similar vein, several empirical studies on inflation have emphasised on factors like
political stability, credibility and reputation of government on inflation determinants. These
kinds of factors vary from traditional inflation theories. Mozayed and Mohhamad (2009) find
that the Iran-Iraq war had a positive significant effect on inflation during the investigated
period. According to Rathnasiri (2009) and Swagel (2001), structural factors such as
industrial and trading policies of government and weather conditions also influence inflation
in developing countries.
Therefore, both demand side and supply side factors have been considered as influencing
factors for inflation in theoretical and empirical literature. This review shows that most of
the causes of inflation identified through empirical evidence are common for developing
countries including Sri Lanka. In fact, the majority of the empirical studies in this area define
inflation by using one of the following measures: the cost of living of the country, exchange
rate, GDP, interest rates, out-put gap, money supply, budget deficit, climate changes, credit
growth, political stability and import price etc.
Hence, this study would contribute to the available literature of inflation by focusing on the
relationship between real, external, monetary and fiscal sectors on the economy and
inflation.
4. Methodology
4.1 The Model
In order to determine the effect of variables on inflation, the following model, which was
developed by Obstfeld and Rogoff (1996) and later modified by Ubide (1997) and Larea and
Sumalia (2001), is applied. The model draws upon several theories relating to the inflation
process and is set in a developing country. Ubide (1997) and Larea and Sumalia (2001) used
this model for identifying inflation dynamics in two developing countries (Mozambique and
Tanzania). Hence, the model is appropriate for analysing inflation dynamics in a developing
country like Sri Lanka.
log !! = ! log !!! + (1 − !)(log !!!" ) (3)

Where, overall price level is P which is the weighted average of the price of tradable goods
(PT) and non-tradable goods (PNT).
0<!<1
The prices of tradable good are assumed to be determined in the world market. Prices of
tradable goods depend on exchange rate (e) and foreign prices (Pf).
45
45
!
log ! ! = log !! + log !! (4)
Therefore, the depreciation (appreciation) of the exchange rate or increase (decrease) in
foreign prices will cause an increase (decrease) in the domestic price level in a small open
economy like Sri Lanka. Thus, it is assumed that the price of non-tradable goods are mainly
determined by money demand and money supply. So, real money supply (Ms/P) equals real
money demand (md) that can be represented by the money market equilibrium condition.
log !!!" = ! (log !!! − log !!! ) (5)

Demand for real money balances can be depicted as follows.
log!!! = !! (log!! ! !! !! ) (6)

So demand for real money balances depend on real money income (y) and interest rates (i).
Interest rate denotes opportunity cost of holding money.
We can obtain the equation of non-tradable goods by substituting Eq. 5 and 6.
log !!!" = ! (log !!! − !! log!! ! !! !! ) (7)

However the main model of this study slightly deviated from the model of Obstfeld and
Rogoff (1996) which has been explained above. Crude oil prices have been considered as
foreign prices in the model. In addition, to capture the government expenditure on inflation,
recurrent expenditure has been included in the model. Long run equation of inflation is
shown in Eq. 8.
!! = ! (!""#! , !"! , !"#! , !"! , !"#$! , !"#! ) (8)
Where; the dependent variable is the inflation level (CCPI Index) and the independent
variables are exchange rate (NEER), government expenditure (EX), gross domestic product
(Real GDP), money supply (MS), crude oil price (OILP) and interest rate proxies by
91 – Treasury bill rate (INT). Hence, several shocks such as real, external, monetary and
fiscal are captured in this study.
4.2 Data and Estimation Method

The CCPI is the official index of inflation in Sri Lanka. As there are several base years, both
CCPI and GDP were converted into base years of 2006/2007 and 2002, respectively.
NEER5 represents the effective exchange rate in the country. Broad money supply (M2) is

5 NEER is an index consisting volume quotation i.e., US$/RS (price of home currency in terms of foreign
currency). The NEER of a given country i is an index number expressed with a base of 100 (or 1) corresponding
to its value at a given point in time t (León-Ledesma, Miguel and Mihailov, 2014).
46
46
used as the measure of money supply. Interest rate is the 91-days Treasury bill rate.
Recurrent expenditure represents government expenditure of the country. All variables are
expressed in logarithmic form, except interest rate. GDP and money supply are seasonally
adjusted. To conduct this study, we have used data from the Central Bank of Sri Lanka
(CBSL). On the basis of data availability, the model was estimated with data of a quarterly
frequency for the period of 2000Q1 to 2013Q4. Broad money supply, GDP, government
expenditure and oil price were in US dollar millions.
Variables used in the empirical analysis are defined in the following manner.
• CCPI = Inflation (Base year - 2006/2007)
• NEER = Nominal Effective Exchange Rate
• EX = Government Recurrent Expenditure
• GDP = Real Gross Domestic Product (Base year -2002)
• OILP = Crude Oil (Brent)Price
• MS = Broad Money Supply
• INT = Interest Rate Represented by 91-days Treasury Bill Rate
Descriptive statistics of data are given in Table 4.
Table 4: Descriptive Statistics
CCPI NEER EX GDP MS OILP INT

Mean 106.99 114.09 1,472.49 5,229.38 10,837.46 65.50 11.30
Median 98.38 104.87 1,342.59 5,119.58 9,381.78 63.75 10.10
Maximum 176.26 168.31 2,969.79 6,818.39 23,348.66 139.30 21.30
Minimun 49.45 88.29 701.01 4,103.44 4,518.17 19.30 6.98
Std. Dev. 40.65 21.90 611.02 717.25 5,741.73 33.96 3.95
Skewness 0.2070 1.0060 0.5943 0.0911 0.7003 0.2643 0.8757
Kurtosis 1.5747 2.9707 2.3444 1.5720 2.2111 1.7912 2.6388
Jarque-Bera 5.1397 9.4448 4.2565 4.8358 6.0295 4.0617 7.4622
Observations 56 56 56 56 56 56 56
Source: Author’s Calculation
Table 4 shows that, on average CCPI and NEER were around 106.99 index points and
114.09 index points, respectively, and interest rates have increased by around 11.30 per cent
per quarter. Money supply amounted to US dollars 10,837.46 million per quarter, while
government expenditure amounted to US dollars 1,472.49 million. GDP was around
US dollars 5,229.38 million in constant terms, while oil prices was US dollars 65.50 per
barrel.
47
47
By following the previous empirical literature (for example: Greenidge and DaCota, 2002;
Odusunya and Atlanda, 2010; Bhashir, 2011 and Sahadudhhen, 2012), we mainly employ the
co-integration method to examine the long run relationship between inflation and other
variables namely money supply, GDP, government expenditure, exchange rate, oil prices and
interest rates. Cointegration means that although many developments can cause permanent
changes in the individual series, there is some long run equilibrium relation trying to keep the
individual components together, representing a linear combination of the set of variables
(Marmol and Velasco, 2004). When non-stationary variables move together over time it is
described as a long run relationship between the variables. Short run disturbances will be
adjusted towards the long run equilibrium. If two or more non-stationary series are having a
long run relationship, they are said to be cointegrated.
The adjustment process in the short run towards the long run equilibrium is captured using
the Vector Error Correction Mechanism (VECM). It permits consistent estimation of the
cointegration space, providing short-run dynamics: movements in the short run which guides
the economy towards the long-run equilibrium. The VECM specification restricts the long
run behaviour of the endogenous variables to converge to their cointegrating relationships,
while allowing a wide range of short run dynamics. The impulse response function will be
used to examine the speed of recovery and adjustment path of inflation to an exogenous
shock. The Granger causality test has been conducted in order to examine the causal
relationship among variables. Variance decomposition tests are also employed in order to
explain how much of a change in a variable is due to its own shock and how much is due to
shocks from other variables.
5. Empirical Analysis
5.1 Unit Root Tests
In the first stage, this study performs the unit root test on each variable in order to examine
the stationary or non-stationary level in a time series data set. If both stationary and non-
stationary variables were included in an equation and estimated by Ordinary Least Squares
(OLS), this will lead to a spurious regression. Therefore, it is important to differentiate
between stationary and non-stationary variables. There are various alternative tests for
testing whether a series is stationary. Commonly used tests are Augmented Dickey-Fuller
(ADF) and Phillips-Perron (PP) tests.
This section conducts the unit root test using Augmented Dickey Fuller (ADF) test and
Phillips-Perron (PP) test. A summary of the unit root test results are presented in Table 5
below.
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48
Table 5: Results of Unit Root Tests
ADF PP
Variable Indicator
Level 1st Difference Level 1st Difference
Statistic -1.0486 -5.1530 -1.4288 -5.0689

LNCCPI
P-Value 0.7294 0.0000 0.5617 0.0001
Statistic -0.6637 -10.1036 -1.6875 -34.4973
LNEX
P-Value 0.8464 0.0000 0.4319 0.0001
Statistic -0.2059 -4.3492 -1.4583 -12.7548
LNGDP
P-Value 0.9307 0.0000 0.5471 0.0000
Statistic -2.2083 -4.7236 -1.8663 -7.5198

INT
P-Value 0.2058 0.0000 0.3445 0.0000
Statistic -1.3743 -7.0355 -1.1267 -8.3809
LNOILP
P-Value 0.5883 0.0000 0.6991 0.0000
Statistic -2.3088 -6.4217 -2.3131 -6.4254
P-Value 0.1729 0.0000 0.1716 0.0000
At levels, the null hypothesis of unit root cannot be rejected for all the variables. Therefore
the ADF and PP were conducted again for the first difference of each variable. The results
show that the non-stationary hypothesis is rejected for the first difference of all the above
variables. This indicates that each variable is integrated in order 1. This concludes that each
variable in the study can be made stationary by taking the first difference. In summary, since
CCPI, MS, NEER, EX, GDP, OILP and INT are integrated in the same order ( I (1) ), these
variables are suitable for the long run cointegration test.
5.2 Preliminary Observations on the Relationships

Several factors behind the volatility of inflation in Sri Lanka are discussed below.
According to the classical theory, increases in money supply have positive effects on the
inflation rate in a country. Without increasing production of goods and services in an
economy, the increase in money supply leads demand pull inflation. Figure 3 below shows a
positive relationship between inflation and money supply. When money supply increased,
inflation also accelerated. The correlation between the two variables is 0.9653.
49
49
Figure 3: CCPI Index and Money Supply

11.0
10.5
10.0
9.5
LNMS 9.0
8.5
8.0
7.5
7.0
3.8 4.0 4.2 4.4 4.6 4.8 5.0 5.2
LNCCPI
If a developing country like Sri Lanka grows fast, productivity will increase in the tradable
sector. It will result in increased wages and an increase in the prices of goods. Figure 4 below
helps to get an idea of the time path of inflation and economic growth. It is clear that higher
inflation is associated with higher growth in GDP. The correlation between inflation and
GDP is 0.5787. Mallik and Chowdhury (2001) find evidence of a long-run positive
relationship between GDP growth rate and inflation for four South Asian countries
(Bangladesh, India, Pakistan and Sri Lanka).
Figure 4: CCPI Index and GDP

10.0
9.5
9.0
LNGDP
8.5
8.0
7.5
7.0
3.8 4.0 4.2 4.4 4.6 4.8 5.0 5.2
LNCCP I
The depreciation of the exchange rate also affects the prices (domestic currency units) of
tradable goods and indirectly affects the general price level. Exchange rate depreciation raises
the domestic price of imported goods, thereby fuelling domestic inflation (Almounsor,
2010). Figure 5 below illustrates the relationship between inflation and the exchange rate
50
50
(NEER) and the correlation coefficient between the two variables are -0.8654. Bhattacharya
(2013) supports this view
view in
in his
his study
study where
where hehe states
states that
that the
thekey
keydrivers
driver of inflation in the
short-run are movements
is the movementininthe
thenominal
nominaleffective
effectiveexchange
exchangerate rateininVietnam.
Vietnam.
Figure 5: CCPI Index and Exchange Rate

6.0
5.5
5.0
LNNEER
4.5
4.0
3.5
3.0
3.8 4.0 4.2 4.4 4.6 4.8 5.0 5.2
LNCCPI
Source: Author’s
Source:
Calculation
Author’s Calculation

Interest rate is another variable which is highly correlated with inflation. If domestic interest
rates are kept low, then it would increase inflation. Studies of Kihangire and Mugyenyi
(2005) and Greenidge and DaCosta (2002) find that a decreased interest rate influence
increases inflation. Figure 6 below represents the fluctuations of inflation and Treasury bill
rates (91 days). There is a negative relationship (-0.3049) between interest rates and inflation.
Figure 6: CCPI Index and Interest Rates

24
20
16
INT
12
0
3.8 4.0 4.2 4.4 4.6 4.8 5.0 5.2
LNCCPI

Ezrim et al (2008) and Bashir et al (2011) find that government expenditure and inflation are
51
51
Ezrim et al (2008) and Bashir et al (2011) find that government expenditure and inflation are
positively related with each other. Government expenditure may result in increasing the price
level, reflecting its fiscal dominance, which could be usually seen in the developing countries.
When government spends more, it would result in pressures on prices through the
expansion of aggregate demand. Figure 7 below illustrates a positive relationship between
inflation and government expenditure and the correlation coefficient between the two
variables are 0.9215.
Figure 7: CCPI Index and Government Expenditure
8.2
LNEX
LNCCPI

A developing country like Sri Lanka mainly depends on imported goods such as crude oil,
wheat, milk etc. Thus, the volatility of international oil prices especially the increasing
domestic price level in the country. Therefore, changes in oil prices are closely related with
inflation. According to Goyal (2011), South Asian countries oil prices and other external
shocks gives a useful opportunity to better understand the structure of inflation of these
economies. Figure 8 below shows a positive relationship between inflation and oil prices.
The correlation between the two variables is 0.9326.
Figure 8: CCPI Index and Oil Price
5.2
4.8
4.4
LNOILP
4.0
3.6
3.2
2.8
3.8 4.0 4.2 4.4 4.6 4.8 5.0 5.2
LNCCP I
52
52
Accordingly, money
Accordingly, money supply,
supply, GDP,
GDP, oil oil prices
prices and
and government
government expenditure
expenditure positively
positively
correlated with inflation, while increasing inflation has shown a sharp depreciation
correlated with inflation, while increasing inflation has shown a sharp depreciation in in the
the
exchange rate
exchange rate (NEER).
(NEER). TheThe interest
interest rate
rate has
has fluctuated
fluctuated considerably
considerably along
along with
with inflation.
inflation.
5.3
5.3 Co-integration
Co-integration Analysis
Analysis (Long
(Long RunRun Analysis)
Analysis)
This study
This study uses
uses thethe cointegration
cointegration analysis
analysis developed
developed by by Johansen
Johansen and
and Juselius
Juselius (1990)
(1990) toto
estimate the long run relationship among variables. The results
estimate the long run relationship among variables. The results of the Johansen of the Johansen co-
integration are are
co-integration reported in Appendix
reported 1. To1.test
in Appendix Tothetestnull
thehypothesis r = 0 against
null hypothesis the general
r = 0 against the
alternative r = 1 , 2 ,3 , 4,5 or 6 , λ
general alternative r = 1,2,3,4,5 ortrace 6, λstatistics should be used. Since λ λ
statistics should be used. Sincetrace statistics of
statistics
trace trace
r =r 0= 0is is
of 143.4142,
143.4142, and
andit itis islarger
largerthan
thanthe
thecritical
criticalvalue
value of
of 125.6154,
125.6154, thethe null hypothesis isis
null hypothesis
rejected at
rejected at the
the 55 per
per cent
cent significance
significance level,
level, so
so that
that the
the variables
variables areare cointegrated
cointegrated using
using thisthis
test. Similar
test. Similar to to the
the λλtrace statistic,
statistic, the
the λ λmax statistic of rr == 00 isis 51.2222,
statistic of 51.2222, and
and itit isis larger
larger
trace max
than the
than the critical
critical value
value of
of 46.2314,
46.2314, the
the null
null hypothesis
hypothesis isis rejected
rejected at
at the
the 55 per
per cent
cent significance
significance
level. So
So the
the λλtrace λmax statistics confirm that there is one co-integration vector.
trace and λ
level. and max statistic confirms that there is one co-integration vector.
Several significant
Several significant findings
findings have
have been
been discovered
discovered from
from this
this analysis.
analysis. The
The result
result of
of the
the
normalised cointegration coefficients are presented in table 6 below.
normalised cointegration coefficients are presented in table 6 below.
Table
Table 6:
6: Normalised
Normalised Cointegration
Cointegration Coefficients
Coefficients
LNCCPI
LNCCPI LNNEER
LNNEER LNEX
LNEX LNGDP
LNGDP LNMS
LNMS LNOILP
LNOILP INT
INT
β�
� Coefficient
Coefficient 1.0000
1.0000 0.6423
0.6423 -0.5498
-0.5498 -0.6800
-0.6800 -0.2365
-0.2365 -0.1183
-0.1183 0.0437
0.0437
Std. Error
Std. Error 0.1192
0.1192 0.0527
0.0527 3.0011
3.0011 0.0712
0.0712 0.0362
0.0362 0.0202
0.0202
t-Statistic 5.3881* -10.4406* -0.2266 -3.3222* -3.2649* 2.1697*

t-Statistic 5.3881* -10.4406* -0.2266 -3.3222* -3.2649* 2.1697*
*Significant at 5% level
*Significant
Source: at 5% level
Author’s Calculation
It is expected that money supply, government expenditure, oil price and GDP exert a
It is expected
positive influencethatonmoney
inflationsupply, government
rates in expenditure,
Sri Lanka and oil rates
that interest price and
andexchange
GDP exert ratesa
positive influence
negatively relate toonthe inflation rates inprocess.
inflationary Sri Lanka and thattointerest
According rates and exchange
the normalised rates
co-integration
negativelyofrelate
equation long to
runthe inflationary
regression; process. According
all variables to the normalised
carry the expected signs duringco-integration
the review
equationTherefore,
period. of long run regression;
the resultant allrun
long variables
model carry the expected
for inflation signs during
determinants for Sri the review
Lanka can
period.
be Therefore,
specified the resultant long run model for inflation determinants for Sri Lanka can
as follows.
be specified as follows.
LNCCPI (-1) = 1.56311 - 0.642LNNEER (-1) + 0.549LNEX (-1) + 0.680LNGDP (-1)
+ 0.236LNMS (-1) + 0.118LNOILP (-1) - 0.043INT (-1) (9)
53
53
53
LNCCPI
Central (-1)of=Sri1.56311
Bank Lanka –-Staff
0.642LNNEER (-1) +
Studies – Volume 450.549LNEX
Numbers 1 & (-1)
2 + 0.680LNGDP (-1)
+ 0.236LNMS (-1) + 0.118LNOILP (-1) - 0.043INT (-1) (9)
Eq. 99 above
Eq. above shows
shows the the long
long term
term dependence
dependence of of inflation
inflation on on the
the variables
variables included
included in in the
the
model. It
model. It has
has been
been found
found that,
that, thethe appreciation
appreciation of of the
the exchange
exchange raterate hashas aa significant
significant
negative
negative impact
impact onon inflation
inflation inin the
the long
long run.
run. The
The appreciation
appreciation of of exchange
exchange raterate by
by 11 per
per cent
cent
isis associated
associated with
with the
the decrease
decrease in in inflation
inflation by by 0.64
0.64 per
per cent.
cent. Wimalasuriya
Wimalasuriya (2008)(2008) found
found that
that
during the
during the period
period 2000-2005,
2000-2005, aa 11 perper cent
cent depreciation
depreciation of of the
the exchange
exchange raterate induced
induced aa 0.3
0.3 per
per
cent increase
cent increase inin retail
retail consumer
consumer prices
prices in in the
the long
long run
run in in Sri
Sri Lanka.
Lanka. TheThe same
same relationship
relationship
has
has been
been observed
observed by by Greenide
Greenide and and DaCosta
DaCosta (2002)
(2002) andand Almounsor
Almounsor (2010).
(2010). According
According to to
Cooray
Cooray (2008)
(2008) and
and Bandara
Bandara (1996)
(1996) the the exchange
exchange raterate isis aa central
central factor
factor in in influencing
influencing Sri Sri
Lankan inflation.
Lankan inflation. The
The depreciation
depreciation in in the
the exchange
exchange raterate can
can cause
cause aa rise
rise in
in import
import prices
prices and
and
itit might
might cause
cause cost
cost push
push inflation.
inflation. In In addition,
addition, thethe exchange
exchange rate rate affects
affects inflation
inflation through
through
supply
supply side.
side. Hence
Hence the the exchange
exchange rate rate isis one
one of
of the
the main
main macroeconomic
macroeconomic fundamentals
fundamentals that that
affect
affect inflation
inflation inin aa small
small open
open economy
economy like like Sri
Sri Lanka.
Lanka. Exchange
Exchange rate rate policies
policies have
have aa role
role to
to
play in
play in stabilising
stabilising inflation
inflation (Kihangire
(Kihangire and and Mugyenyi,
Mugyenyi, 2005).
2005).
The long
The long run
run inflation
inflation function
function indicated
indicated that
that government
expenditure hashas aa positive
positive impact
impact
on
on inflation.
inflation. When
When government
expenditure isis increased
increased byby 11 per
per cent,
cent, the
the inflation
inflation rate
rate also
also
increases by
increases by 0.55
0.55 per
per cent
cent in
in the
the long
long run.
run. When
When government
government spending
spending isis increased,
increased, itit would
would
result in
result in pressures
pressures onon prices
prices through
through the the expansion
expansion in in aggregate
aggregate demand.
demand. Also,
Also, the
the internal
internal
conflict
conflict that prevailed in in Sri
Sri Lanka
Lanka foraround
aroundthethree
last three-four
decades made decades made a volatility
a significant significantin
volatility
inflation inandinflation
further, and
the further, the high
high defence defence expenditure
expenditure was a majorwas a major
burden burden on
on government
spending. The
government positiveThe
spending. impact of government
positive expenditure expenditure
impact of government on inflationonmay have been
inflation may
strengthened
have by defence by
been strengthened expenditure among otheramong
defence expenditure components of government
other components of expenditure.
government
expenditure.
For example,For example,(2011)
Magazzino Magazzino
reveals(2011) reveals
that there is a that thererelationship
long-run is a long-run relationship
between public
between public expenditure/GDP
expenditure/GDP growth and inflationgrowth forand inflation for Portugal.
Portugal.
In the
In the same
same manner,
manner, economic
economic growth
growth caused
caused by
by increased
increased aggregate
aggregate demand
demand leads
leads toto an
an
acceleration in
acceleration in inflation
inflation in
in the
the economy.
economy. When
When thethe GDP
GDP increases
increases by
by 11 per
per cent,
cent, the
the
inflation
inflation rate
rate will
will increase
increase by
by 0.68
0.68 per
per cent.
cent. Bandara
Bandara (2011),
(2011), Callen
Callen and
and Chang
Chang (1999),
(1999),
Bhattacharya
Bhattacharya (2013)
(2013) and
and Greenide
Greenide and
and DaCosta
DaCosta (2002)
(2002) have
have found
found that
that GDP
GDP isis aa key
key driver
driver
of inflation
of inflation in
in the
the long
long run
run through
through the
the demand
demand side
side of
of the
the economy.
economy.
This shows
This shows thatthat 11 per
per cent
cent increase
increase inin money
money supply
supply will
will increase
increase inflation
inflation by
by 0.24
0.24 per
per cent.
cent.
Since
Since all
all the
the variables
variables are
are expressed
expressed in in logarithm,
logarithm, thethe estimated
estimated coefficients
coefficients are
are interpreted
interpreted asas
elasticities.
elasticities. Price
Price elasticity
elasticity with
with respect
respect to to money
money supply
supply is 0.24.
0.24. Devapriya
Devapriya and and Ichihashi
Ichihashi
(2012) found
(2012) found that
that during
during the
the period
period 1950-2010,
1950-2010, aa 11 perper cent
cent change
change in in growth
growth rate
rate of
of money
money
supply will
supply will induce
induce 0.18
0.18 positive
positive change
change in in the
the inflation
inflation rate
rate in
in Sri
Sri Lanka.
Lanka. DueDue to
to high
high money
money
supply, investments will
supply, investments will increase
increaseand andmoremore employment
employment opportunities
opportunities will generate.
will generate. As a
result
As aggregate
a result demand
aggregate will increase
demand and ultimately
will increase there will
and ultimately be an
there willincrease
be an in domestic
increase in
price levels
domestic due levels
price to higher
due demand.
to higherAccordingly, money supply
demand. Accordingly, affects
money inflation
supply through
affects the
inflation
through the demand side. Weerasekara (1992), Laryea and Sumaila (2001) Ratnasiri (2009),
Odusunya and Atanda (2010), Bandara (2011), Bashir (2011), Sahdudhhen (2012) and Arif
and Ali (2012) also found that money supply has a long run significant impact on inflation.
54
54
54
However, results of long run analysis found that the exchange rate has a higher impact on
inflation than money supply. These improvements have included greater clarity and
transparency with respect to monetary objectives and instruments as well as greater exchange
rate flexibility (Osorio and Unsal, 2011). And the contribution of monetary shocks to
inflation may diminish over time, perhaps reflecting the improvements in monetary
frameworks in the country.
In the same manner, oil prices indicate a positive impact on inflation. When oil prices
increase by 1 per cent, the inflation rate increases by 0.12 per cent in the country. Due to
higher oil prices, expenditure on imports will increase and investments will decline
accordingly. As a result, the production of goods and services will reduce and it will impact
the acceleration of inflation. According to Kihangire and Mugyenyi (2005), higher oil prices
affect oil importing economies in two ways and could lead to an increase in firms’
production costs and reduce profits.
Moreover, inflation and interest rates are correlated with each other. Studies by Greenidge
and Da Costa (2002) and Kihangire and Mugyenyi (2005) find that the decrease in interest
rates influence increased inflation. The empirical results show that the interest rate has a
marginal impact on inflation. Accordingly, the increase of 1 per cent in interest rates leads to
around 0.04 per cent decrease in inflation. When the interest rate increases more than the
inflation rate, it leads to increase or constant savings and decreased expenditure on goods
and services. As a result of decrease in money demand, the money supply also decreases.
Thus, there will be a downward trend in domestic prices.
5.4 Vector Error Correction Estimates (Short Run Analysis)

Given that the above mentioned variables are cointegrated, the next step is to estimate the
Vector Error Correction Estimates (VECM). A summary of the VECM results are presented
in Table 7 below.
Each error correction equation includes the error correction coefficient (α ) , error correction
term lagged once ( ut −1 ), current and first lag values of variables of the first difference of each
variable. All regressors in the ECM models are predetermined and are one quarter ahead
predicted values and they are true ex-ante forecasts. First row includes error correction
coefficients.
55
55
Table 7: Summary Results of VECM

Table 7: Summary Results of VECM
D D D D D D D
(LNCCPI)
D (LNNEER)
D (LNEX)
D (LNGDP)
D (LNMS)
D (LNOILP)
D (INT)
D
α
� (LNCCPI) (LNNEER) (LNEX) (LNGDP) (LNMS) (LNOILP) (INT)
-0.0640 0.3434 0.8635 0.0098 0.0839 -0.1303 -0.0868
Coefficient
�
-0.0640 0.3434 0.8635 0.0098 0.0839 -0.1303 -0.0868
Coefficient
Std. Error 0.0843 0.1449 0.4973 0.0112 0.1469 0.8774 0.8912
Std. Error 0.0843 0.1449 0.4973 0.0112 0.1469 0.8774 0.8912
t-Statistic -0.7594 2.3696* 1.7365 0.8777 0.5712 -0.1485 -0.9742
t-Statistic
*Significant at 5%-0.7594
level 2.3696* 1.7365 0.8777 0.5712 -0.1485 -0.9742
*Significant at 5% levelCalculation
Source: Author’s
The magnitude of each error correction term shows how quickly the deviation of each
The magnitude
variable from the of long
each run
errorequilibrium
correctionisterm showsgradually
corrected how quickly
towardsthethe
deviation of each
equilibrium level
variable
throughfrom the long
a series run equilibrium
of partial is corrected gradually
short run adjustments. Short runtowards
dynamics theshow
equilibrium
in lag 1level
(-1).
through a series
T statistics of partial
of (-1) short run
coefficients adjustments.
of these variablesShort runthat
explain dynamics
these show in lag
variables are 1weakly
(-1).
Texogenous.
statistics ofHowever,
(-1) coefficients
the errorofcorrection
these variables
term hasexplain that these
a negative sign asvariables
expected.areThe
weakly
error
exogenous. However, the error correction term has a negative sign as expected.
correction model of the inflation rate is -0.0640. The interpretation of this error correction The error
correction
term is thatmodel
onceofthetheinflation
inflationrate
ratedeviates
is -0.0640. Thetheinterpretation
from of thisdetermined
equilibrium value error correction
by the
term is that once
fundamentals, thethe inflation rate
adjustment rate deviates from therate
of the inflation equilibrium
is 6.40 pervalue
centdetermined
on quarterlyby basis.
the
fundamentals, the adjustment
This can be considered rate
as quite of the
a slow rateinflation rate is 6.40 per cent on quarterly basis.
of adjustment.
This can be considered as quite a slow rate of adjustment.
5.5 Impulse Response Analysis

5.5 Impulse Response Analysis
Impulse response functions trace the impact of a shock emanating from endogenous
Impulse
variablesresponse
to other functions trace the impact
variables (Almousor, 2010). Inof this
a shock
sectionemanating from endogenous
the study investigates how an
variables
exogenousto other
shockvariables (Almousor,
to a variable affects 2010).
other In this section
variables in thethe studythrough
model investigates how anof
an analysis
exogenous shock
their impulse to a variable
response affects
functions. The other
resultsvariables
of impulse in response
the modelfunction
throughanalysis
an analysis of
are given
their impulse
in Figure response functions. The results of impulse response function analysis are given
9 below.
in Figure 9 below.
56
56
56
Figure 9: Results of Impulse Response Analysis
Response to Cholesky One S.D. Innovations ± 2 S.E.

Response of D(LNCCPI) to D(LNCCPI) Response of D(LNCCPI) to D(LNMS) Response of D(LNCCPI) to D(LNNEER)
.020 .020 .020
.016 .016 .016
.012 .012 .012
.008 .008 .008
.004 .004 .004
.000 .000 .000
-.004 -.004 -.004
-.008 -.008 -.008
-.012 -.012 -.012

1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Response of D(LNCCPI) to D(LNEX) Response of D(LNCCPI) to D(LNGDP) Response of D(LNCCPI) to D(OILP)

.020 .020 .020
.016 .016 .016
.012 .012 .012
.008 .008 .008
.004 .004 .004
.000 .000 .000
-.004 -.004 -.004
-.008 -.008 -.008
-.012 -.012 -.012

1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Response of D(LNCCPI) to INT

.020
.016
.012
.008
.004
.000
-.004
-.008
-.012
1 2 3 4 5 6 7 8 9 10
In impulse response results, we find that a positive shock of CCPI to the inflation has a
positive effect on inflation until 3 periods and then stabilize gradually. It proved that
domestic price shocks lead to more inflation. The response of inflation to money supply
shows that money supply will have an expansionary effect until 2 quarters and stabilizes
thereafter. The appreciation of exchange rate has a significant negative impact on inflation
over the medium term horizon of 8 quarters. Accordingly, the inflation response to
appreciation on the exchange rate is immediate. Almounsor (2010) also found that the
nominal appreciation on the exchange rate reduces inflation. Government expenditure has a
small negative impact on inflation until 6 quarters and gradually stabilises. However, it is not
in line with what is expected and observed. A positive shock to the GDP will have an
expansionary effect on inflation in 2 periods and a contractionary effect over the medium
term. Shock to oil prices has positive impact on inflation until 2 periods. On the other hand,
57
57
the decrease in interest rates has a positive impact on inflation until 5 quarters and gradually
stabilises thereafter. The result of interest rates on the Granger causality test is consistent
with results of Ratnasiri (2009) who has done a VAR based analysis. The impulse responses
suggest that external shocks (i. e., exchange rate and oil prices) have an increasing impact on
inflation. Also, domestic shocks associated with money supply, interest rates and GDP have
an increasing impact on inflation over short term.
5.6 Variance Decomposition

The results of the variance decomposition of the CCPI are given in Appendix 2.
The variance decomposition of the CCPI gives the changes in the growth in CCPI
attributable to each of the other variables included in the model as well as itself. After 5
periods, the CCPI is explained more than 65 per cent by itself and interest rates and oil
prices contribute around 19 per cent and 7 per cent respectively. Hence, the variance
decomposition of inflation indicates that short run dynamics in inflation are explained
mostly by its own fluctuations, followed by interest rates and oil prices. After 10 periods,
about 50 per cent of the variance in the inflation is explained by inflation itself. About 20 per
cent variance in inflation is from interest rates; about 15 per cent and 7 per cent variances are
from government expenditure and oil prices. Other variables contribute very little to
explaining inflation after 10 periods. This result shows that inflation itself, government
expenditure and interest rates accounted for over 85 per cent variability in the inflation after
10 periods.
5.7 Diagnostic Tests

Several diagnostic test namely serial correlation test, heteroskedasticity test and normality
tests were performed. A detailed description of diagnostic tests is shown in Appendix 3.
First, serial correlation tests were conducted. Serial correlation determines how well the past
values of a variable predict the future value of the same variable. At 5 per cent significance
level, it fails to reject the hypothesis that there is no serial correlation issue in variables.
Secondly, heteroskedasticity tests were performed. Since the p value of Chi-Square (0.1455)
is not less than 0.05, it does not reject H0, which means that there is no heteroaskedasticity.
The final diagnostic test was done by conducting the normality test. According to the
normality test, since p-value is 0.0700 which is greater than 0.05, we do not reject H0 at 5 per
cent level of significance and it can be concluded that residual are normally distributed.
58
58
6. Conclusions and Policy Implications

This paper reviews the impact on key macroeconomic determinants of the inflation in Sri
Lanka covering the period of 2000–2013 for quarterly data. As such, this study would
contribute to the available literature of inflation by focusing on the relationship of inflation
with real, external, monetary and fiscal sectors of the economy. In particular, existing studies
on inflation in Sri Lanka do not consider the fiscal effect on inflation in detail. Thus, most of
the research in this area have not considered oil price changes on inflation in Sri Lanka.
Moreover, under significant structural changes of the economy after the end of the internal
conflict and the persistence of current low inflation situation in Sri Lanka, identifying the
determinants of inflation is vital for policy makers in their effort in maintaining price stability.
Depending on the necessity, tests and models such as unit roots, cointegration analyses,
VECM, impulse response and variance decomposition tests were employed. According to
the results of the research, several determinants of Sri Lanka’s inflation have been identified.
The study revealed that both long run and short run factors influence inflation in Sri Lanka.
Based on the results of the model, exchange rate, money supply, GDP, government
expenditure, oil prices and interest rate explain inflation in Sri Lanka. This study found that
increase in the money supply will increase domestic price level in the country. Due to higher
money supply, investments will increase and more employment opportunities will be
generated. As a result, the aggregate demand will increase and ultimately there will be an
increase in domestic price level due to higher demand. Accordingly, money supply affects
inflation through demand side. Further, there is a strong positive link between inflation and
the exchange rate. The exchange rate is one of the main macroeconomic fundamentals that
affect inflation in a small open economy like Sri Lanka.
Government expenditure also affects inflation through demand side. Higher expenditure
increases the aggregate demand of goods and services. This would result in higher domestic
price levels. In the same manner, GDP has a positive impact on inflation. Consequently, it
has shown that there is a positive relationship between international oil prices and inflation.
Thus empirical findings indicate that the decreasing interest rates have a positive effect on
inflation in Sri Lanka. Therefore, it has proved that in the long run, both supply side and
demand side factors namely, money supply, exchange rate, government expenditure, oil price
GDP and interest rates play important roles in the inflation process in Sri Lanka during the
investigated period.
In the short run, the error correction term has negative sign as expected and there is quite a
low rate of adjustment. Impulse responses suggest that key drivers of inflation in the short
term are exchange rate, money supply, interest rates, oil prices and GDP. Results of Variance
decomposition results revealed that inflation itself, government expenditure and interest
rates accounted for over 85 per cent variability in the inflation after 10 periods. Therefore, it
has been proved that both demand pull and cost push factors affect inflation in Sri Lanka as
shown by Ratnasiri (2009).
59
59
According to the above results, a number of policy implications can be derived. First small
open economies like Sri Lanka experience demand pull inflation due to the impact of
expansionary monetary and fiscal policies. As highlighted by Almousor (2010), over the
medium term, close coordination between monetary policy and fiscal policy is important to
alleviate inflationary pressures. Policies include wage control, monetary policy (reduction in
money supply) and fiscal policy (increase in personal income tax and reduction in
government expenditure) and increase in output of goods and services will help in
controlling inflation in Sri Lanka.
As GDP is a main factor affecting inflation in Sri Lanka, the results of this study emphasise
the need to create a stable macroeconomic policy environment to promote growth in an
effort to maintain price stability. Also, policy makers need to give their attention to inflation-
growth relationship which is a relatively under-explored area. Attempts to reduce inflation to
a very low level (or zero) are likely to adversely affect economic growth (Mallik and
Chowdhrury, 2001). Hence, the challenge for policymakers is to find a growth rate which is
consistent with a stable inflation rate in Sri Lanka. Although a country needs inflation for
growth, significantly high growth rates may accelerate the inflation rate as found by Bruno
and Easterly (1998).
Keynesian style demand side policies alone would not be enough to reduce inflation. Supply
side factors like exchange rate and oil prices are important determinants in inflation. Greater
volatility of exchange rate will result in higher volatility in inflation. This study has found that
the exchange rate has a significant impact on inflation in Sri Lanka. Hence, exchange rate is
one of the main macroeconomic fundamentals that affect inflation in a small open economy
like Sri Lanka. As Sri Lanka is a net importer of crude oil, volatility on international oil prices
has a positive impact on inflation. Nguyen et al (2012) explain that external shocks such as
oil prices are difficult to avoid in a small open economy. Accordingly exchange rate
movements and international oil prices have both short-run and long-run effects on the
inflation. The impact of increased foreign prices such as crude oil could be off-set to some
extent by managing the exchange rate at an appropriate level. Finally, higher government
expenditure would lead to higher inflation in a country. Government expenditure affects
through demand side, as with high expenditure, aggregate demand of goods and services will
increase and it would lead to higher overall prices in the economy (Bashir, 2011). Hence
targeting a low inflation level together with tight fiscal policy would help to reduce inflation
level in the country.
There are a few limitations in this study. Temporary shocks that raise domestic prices such as
weather related factors or other commodity shocks have not been addressed in this paper.
These factors may be dominant inflation triggers. Hence, expanding the analysis by including
more variables such as weather related factors, credit growth, political stability etc. may lead
to more robust results. Moreover, the use of alternative methods such as SVAR and FAVAR
(for example: Osairo and Unsal, 2011) would help to deepen understanding of dynamics of
inflation in Sri Lanka. Future research can consider the above directions in order to derive
firm policy conclusions.
60
60
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64
64
Appendix 1
Appendix
Appendix1 1
Johansen Test for Cointegration
Johansen
JohansenTest
Testfor
forCointegration
Cointegration
0.05 Critical Values
Test Statistics
Hypothesized No. of
CE(s) 0.05
0.05Critical
CriticalValues
Values
Test Max-Eigen
TestStatistics
Statistics
Hypothesized
HypothesizedNo.
No.ofof Trace Statistic Trace Max-Eigen
Statistic
CE(s)
CE(s)
Max-Eigen
Max-Eigen
None * Trace
TraceStatistic
Statistic
143.4142 51.22223 Trace
Trace
125.6154 Max-Eigen
Max-Eigen
46.23142
Statistic
Statistic
At most 1 92.19198 34.12467 95.75366 40.07757
None
None* * 143.4142
143.4142 51.22223
51.22223 125.6154
125.6154 46.23142
46.23142
At most 2 58.06732 24.38630 69.81889 33.87687
AtAtmost
most1 1 92.19198
92.19198 34.12467
34.12467 95.75366
95.75366 40.07757
40.07757
At most 3 33.68102 20.69609 47.85613 27.58434
AtAtmost
most2 2 58.06732
58.06732 24.38630
24.38630 69.81889
69.81889 33.87687
33.87687
At most 4 12.98493 7.823024 29.79707 21.13162
AtAtmost
most3 3 33.68102
33.68102 20.69609
20.69609 47.85613
47.85613 27.58434
27.58434
At most 5 5.161909 5.151201 15.49471 14.26460
AtAtmost
most4 4 12.98493
12.98493 7.823024
7.823024 29.79707
29.79707 21.13162
21.13162
At most 6 0.010708 0.010708 3.841466 3.841466
AtAtmost
most5 5 5.161909
5.161909 5.151201
5.151201 15.49471
15.49471 14.26460
14.26460
AtAtmost
most6 6 0.010708
0.010708 0.010708
0.010708 3.841466
3.841466 3.841466
3.841466
Appendix 2
Results of Variance Decomposition Appendix
Appendix2 2
Period S.E. LNCCPI Results
Results
LNNEER ofofVariance
Variance
LNEX Decomposition
Decomposition
LNGDP LNMS LNOILP INT
1 0.015526 100.0000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000
Period
Period S.E.
S.E. LNCCPI
LNCCPI LNNEER
LNNEER LNEX
LNEX LNGDP
LNGDP LNMS
LNMS LNOILP
LNOILP INT
INT
2 0.028879 92.34880 0.010468 1.110741 1.663374 0.027925 0.181348 4.657339
11 0.015526
0.015526 100.0000
100.0000 0.000000
0.000000 0.000000
0.000000 0.000000
0.000000 0.000000
0.000000 0.000000
0.000000 0.000000
0.000000
3 0.039214 79.89355 0.664895 2.710622 1.388850 0.015391 3.878408 11.44829
22 0.028879
0.028879 92.34880
92.34880 0.010468
0.010468 1.110741
1.110741 1.663374
1.663374 0.027925
0.027925 0.181348
0.181348 4.657339
4.657339
4 0.047689 69.78947 0.863180 4.285550 1.863999 0.126407 6.021076 17.05032
33 0.039214 79.89355
0.039214 79.89355 0.664895
0.664895 2.710622
2.710622 1.388850
1.388850 0.015391
0.015391 3.878408
3.878408 11.44829
11.44829
5 0.054317 64.69302 1.259049 5.950861 2.021374 0.136882 6.593631 19.34519
44 0.047689 69.78947
0.047689 69.78947 0.863180
0.863180 4.285550
4.285550 1.863999
1.863999 0.126407
0.126407 6.021076
6.021076 17.05032
17.05032
6 0.060325 59.84908 1.647806 8.419882 2.956293 0.153606 7.009425 19.96391
55 0.054317 64.69302
0.054317 64.69302 1.259049
1.259049 5.950861
5.950861 2.021374
2.021374 0.136882
0.136882 6.593631
6.593631 19.34519
19.34519
7 0.065099 55.67246 2.162705 11.01335 3.417938 0.139577 7.268367 20.32560
66 0.060325 59.84908
0.060325 59.84908 1.647806
1.647806 8.419882
8.419882 2.956293
2.956293 0.153606
0.153606 7.009425
7.009425 19.96391
19.96391
8 0.068693 52.68285 2.481547 12.85160 4.046059 0.180549 7.195480 20.56191
77 0.065099 55.67246
0.065099 55.67246 2.162705
2.162705 11.01335
11.01335 3.417938
3.417938 0.139577
0.139577 7.268367
7.268367 20.32560
20.32560
9 0.071345 50.92168 2.935552 14.04401 4.232004 0.207482 7.124490 20.53478
88 0.068693 52.68285
0.068693 52.68285 2.481547
2.481547 12.85160
12.85160 4.046059
4.046059 0.180549
0.180549 7.195480
7.195480 20.56191
20.56191
10 0.073769 49.53084 3.251606 15.12357 4.484202 0.240756 7.066291 20.30274
99 0.071345 50.92168
0.071345 50.92168 2.935552
2.935552 14.04401
14.04401 4.232004
4.232004 0.207482
0.207482 7.124490
7.124490 20.53478
20.53478
1010 0.073769 49.53084
0.073769 49.53084 3.251606
3.251606 15.12357 4.484202
15.12357 4.484202 0.240756
0.240756 7.066291
7.066291 20.30274
20.30274
Source:
Source:Author’s
Author’sCalculation
Calculation
65
65
6565
Appendix 3
Results of Diagnostics Tests

(1) Serial Correlation LM Test
Lags LM-Stat Probability

1 57.02089 0.2015
2 75.66529 0.1086
3 43.04227 0.7123
4 61.75365 0.1044
5 55.08815 0.2553
6 59.18262 0.1512
7 56.75604 0.2084
8 53.06927 0.3202
9 53.20709 0.3155
10 38.18978 0.8677
(2) Heteroskedasticity Test
Chi-Sq DF Probability
883.3377 840 0.1455
(3) Normality Test
Component Jarque-Bera df Prob.

1 2.939448 2 0.2300
2 2.008116 2 0.3664
3 4.062167 2 0.1312
4 6.205006 2 0.0449
5 3.273492 2 0.1946
6 1.361198 2 0.5063
Joint 19.84943 12 0.0700
66
66

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Inflation

Table 1: Sri Lanka and World Inflation (Annual Average % Change)

Country 1980 1990 2000 2010 2013

contribute to the available literature on inflation by focusing on the relationship of inflation

2. Inflation in Sri Lanka

Table 2: Annual Average Inflation (1948-2014)

Period Inflation (%)

Figure 1: Annual Inflation in Sri Lanka

2.2 Measures of Inflation in Sri Lanka

Table 3: Colombo Consumers’ Price Index: Weights by Main Categories

1. Food and Non-alcoholic Beverages 46.7 41.0

3.2 Empirical Evidence

3.3 Sri Lankan Context

log !! = ! log !!! + (1 − !)(log !!!" ) (3)

log !!!" = ! (log !!! − log !!! ) (5)

log!!! = !! (log!! ! !! !! ) (6)

log !!!" = ! (log !!! − !! log!! ! !! !! ) (7)

4.2 Data and Estimation Method

Descriptive statistics of data are given in Table 4.

Table 4: Descriptive Statistics

CCPI NEER EX GDP MS OILP INT

Table 5: Results of Unit Root Tests

Statistic -1.0486 -5.1530 -1.4288 -5.0689

Statistic -2.2083 -4.7236 -1.8663 -7.5198

5.2 Preliminary Observations on the Relationships

Figure 3: CCPI Index and Money Supply

Source: Author’s Calculation

Figure 4: CCPI Index and GDP

Source: Author’s Calculation

Figure 5: CCPI Index and Exchange Rate

Figure 6: CCPI Index and Interest Rates

Source: Author’s Calculation

Source: Author’s Calculation

Figure 8: CCPI Index and Oil Price

Source: Author’s Calculation

t-Statistic 5.3881* -10.4406* -0.2266 -3.3222* -3.2649* 2.1697*

5.4 Vector Error Correction Estimates (Short Run Analysis)

Table 7: Summary Results of VECM

5.5 Impulse Response Analysis

Figure 9: Results of Impulse Response Analysis

Response to Cholesky One S.D. Innovations ± 2 S.E.

.016 .016 .016

.012 .012 .012

.008 .008 .008

.004 .004 .004

.000 .000 .000

-.004 -.004 -.004

-.008 -.008 -.008

-.012 -.012 -.012

Response of D(LNCCPI) to D(LNEX) Response of D(LNCCPI) to D(LNGDP) Response of D(LNCCPI) to D(OILP)

.016 .016 .016

.012 .012 .012

.008 .008 .008

.004 .004 .004

.000 .000 .000

-.004 -.004 -.004

-.008 -.008 -.008